New Sunday Times Feature - Diary of a Private Investor

[Colm Fagan]

@WhiteCoat Sorry for the delay in getting back to you, but I was at a family event - wife's family event - in Limerick, and only got back this evening.

You've raised a number of technical and moral issues. If you don't mind, I'll stick to the technical issues, where I'm more at home. I'm still unsure where I stand on some of the moral issues.

I feel like an undergrad again....pls bear with me!

Please don't consider me as a lecturer or a professor. I'm an amateur investor. I've never worked in an investment department and my only investment "qualification" is what I learned in the investment module of the actuarial exams more than 45 years ago. I do have a lot of practical experience however, gained over the last 22 years from managing my own pension assets.

Firstly, I don't understand the relevance of the earnings per share metric. For example, if a company did a share split (2 to 1), an investor's earnings per share is immediately halved. What's the problem with this? Has the overall return prospects of an investor in such a company been damaged by such an action and if so why would a company engage in such activity?

What I'm talking about has nothing to do with share splits. Share splits achieve nothing: a 2 for 1 share split means that I've got twice as many shares, at half the price, so forget about them. They're not relevant to our discussion.

Looking at share buybacks, Say Ryanair has earnings of €100m and there are 100 million shares in issue. Earnings per share are €1. Ryanair also has oodles of cash on its balance sheet, generating damn all interest. Say it has €50 million spare cash on its balance sheet and assume also that the share price is €10. It can use its cash to buy back and extinguish 5 million shares. Now the earnings of €100 million are being allocated to just 95 million shares, resulting in earnings per share of just over €1.05 (100/95), compared with €1 before. The cake is being divided among a smaller number of mouths. If the share price falls below €10, then the €50 million will buy back more than 5 million shares, so earnings per share increase still further. That's the point I was trying to make.

Secondly, if you believe your conclusions, shouldn't you actually invest in tobacco, gambling and other bad boys (especially those with similar buy back practices?)

First of all, not all companies can do share buy-backs. They must have the readies to buy them. My initial response to the Duke is the right one (I think) if the company is not buying back shares. For the companies that do share buy-backs, it would seem to be a crazy strategy to buy as many as possible of the shares at an inflated price, just so that they could buy back less shares! In effect, you would be ensuring a higher exit price for people who had offered their shares in the buyback.

By extension, do similar points not apply (in a kind of reversal) to share buy backs? Otherwise, wouldn't all companies be at it? Surely, ir can't be some sort of secret returns weapon that only some companies have worked out?

I think the above response addresses this point also.
PS: I don't know how the graph appeared as an attachment. That's something else I was working on, and it appeared here by accident. Now I can't remove it!!!! Please ignore.

 

[Duke of Marmalade]

@WhiteCoat We actually help to INCREASE its earnings per share by shunning it. This paradoxical result stems from the fact that Ryanair is a cash machine. Instead of giving the cash back to shareholders as dividends, it repurchases shares in the market and extinguishes them.

Colm, I'm struggling with this point. Leaving tax considerations aside and assuming markets are rational (uhh) whether you get your cash in dividends or in share buybacks adds no economic value and should be irrelevant. Under the latter you finish up with less shares on a higher yield, but same earnings in total. Of course if markets irrationally attach the same P/E ratio ex dididend as they do cum dividend then you are effectively getting a share type P/E being attached to the lost interest on the dividends.

But getting back to the main point, let's say ethical investors result in BadCo's shares being constantly valued at a 50% discount to their true economic value. Does this help BadCo to carry out its mission statement which is "to spread wickedness wheresoever it can"? The only time the share price can affect BadCo's strategy is when it wants to raise money on the stock exchange and I don't see how a 50% discount helps it do that and a I don't see how share buy backs affect that argument.

 

[Colm Fagan]

Duke. My latest post explains how I arrived at that paradoxical conclusion. I have equated "shunning" to lowering the price. Cancelling shares by buying them back at a lower price and then extinguishing them results in a higher EPS.

whether you get your cash in dividends or in share buybacks adds no economic value and should be irrelevant

Except that it's two different groups of shareholders. If it's dividends, then all the shareholders are treated the same. If it's a buy-back (at a cheap price), one group of shareholders has managed to get rid of another group by paying them off cheaply. OK, the remaining shareholders have to pay cash to buy them off, but the cash was rotting in the bank account anyway. It would be different if the cash had to be borrowed to pay them off. Of course, the balance sheet is also weaker after the payment.

 

[Duke of Marmalade]

Ok, I see the different groups of shareholders argument. But where does an undervalued share price help BadCo to carry out its wicked mission?

There is still something illusory about this buyback thing. Say the company decides instead of paying a dividend to buy back shares. For sure some will sell and some will not thus having the effect that the sellers will have sold more of their value in the company than if they had simply received a dividend and vice versa the others will have bought shares with the foregone dividend and more. Okay, so one group has consciously increased its weighting and the other has reduced its. But they could have achieved the exact same result in the secondary market if they had received a dividend. I don't see what the share buyback achieves per se.

 

[Colm Fagan]

Duke, I started this particular hare running by talking about relativities. I want to keep to the relativity issue for now.

Let's say I agree with you (and I probably do) that, in normal times, a share buyback achieves nothing. The shares are bought back at a "fair" price and everyone is equally happy/ unhappy. Now we introduce a few "do-gooders" who decide to sell/ short BadCo's shares and bring the price down to P-delta, the delta having no rational economic justification, its only justification being the discount for "badness" caused by shorting "do-gooders".

Now BadCo starts buying back shares at P-delta. It buys back more shares from departing shareholders than it would have bought if the do-gooders hadn't intervened. The universe hasn't changed, so the total value in the system is unchanged, but the departing shareholders have lost and the continuing shareholders have gained. Remember too that there are now more departing shareholders than there would have been if the buyback was completed at price P.

 

[Colm Fagan]

Sorry, Duke. I didn't answer your question. Shows why I took so long to pass the exams! I didn't claim that it helped BadCo to carry out its evil mission, just that it would improve the earnings per share, which presumably makes it more attractive as an investment.

 

[Duke of Marmalade]

Duke, I started this particular hare running by talking about relativities. I want to keep to the relativity issue for now.

Let's say I agree with you (and I probably do) that, in normal times, a share buyback achieves nothing. The shares are bought back at a "fair" price and everyone is equally happy/ unhappy. Now we introduce a few "do-gooders" who decide to sell/ short BadCo's shares and bring the price down to P-delta, the delta having no rational economic justification, its only justification being the discount for "badness" caused by the shorting by "do-gooders".

Now BadCo starts buying back shares at P-delta. It buys back more shares from departing shareholders than it would have bought if the do-gooders hadn't intervened. The universe hasn't changed, so the total value in the system is unchanged, but the departing shareholders have lost and the continuing shareholders have gained. Remember too that there are now more departing shareholders than there would have been if the buyback was completed at price P.

Agree with all that.

 

[WhiteCoat]

Thanks for the response, Colm

I didn't get a chance to reply before now.

Let's see have I got this right! It seems that under certain conditions there are advantages in share buy backs, particular where the shared price is below what is deemed its “true” value. It also seems that it's quite marginal because the enterprise no longer has the capital that it has used up in doing the share re-purchase. So the investor's greater proportion of future earnings post the buy back needs to be compared with what would otherwise have been a marginally lower % holding in a bigger enterprise. The enterprise would be bigger (where buy back doesn't occur) because capital is retained in the enterprise and presumably set to work, i.e. it won't languish in cash for ever. So the investor's share in the non buy back environment includes a percentage of the capital that would otherwise have been used in the buy back together with the additional/marginal directly associated earnings. Is this fair?


If yes are we not back to the much simpler "if I buy shares in a company, I want it to succeed, I don't want BadCo to succeed?" From an eco-ethical investment perspective or at least “what I would like to see happen perspective”, I would actually want Ryanair to continuously engage in buy backing because Ryanair would then grow at a slower rate. The alternative is that the Cash Reserves would simply serve as a war-chest and be used to buy even more planes, set up even more routes and cause even more trumpeting of on-time arrivals.

 

[WhiteCoat]

Colm,

On a separate point, I have read with great interest your Auto-enrolment submission. It seems to address very many of the key risks. I will re-read and make some comments. In the meantime, how big could the overall fund become when fully mature and who underwrites it / what happens if something really, really bad happens in markets when the fund is mature?

 

[Duke of Marmalade]

If yes are we not back to the much simpler "if I buy shares in a company, I want it to succeed, I don't want BadCo to succeed?"

Yes you might have a conflict of interest. That doesn't necessarily mean you are behaving unethically even by your own compass. For example, I might have backed Donald Trump to win the presidential race because the odds looked good. I could still be in the position that I did not want him to win; even thought it would be unethical to help him in any way. Now if instead of betting on him I had contributed to his election fund then I truly would be affronting my principles.
By analogy, and ignoring tenuous secondary effects, if I buy shares in BadCo I am not contributing to BadCo. I might simply be availing of a second hand bargain because the ethical brigade are causing a false market.

 

[Duke of Marmalade]

Colm,

On a separate point, I have read with great interest your Auto-enrolment submission. It seems to address very many of the key risks. I will re-read and make some comments. In the meantime, how big could the overall fund become when fully mature and who underwrites it / what happens if something really, really bad happens in markets when the fund is mature?

I thought you said your profession was eponymous. This question shows that you have acumen beyond the medical sphere. It is a question which I have asked myself. One possible response (though I would be interested to hear from the man himself) is that such a scenario would be so dire that much else would be going wrong - food shortages, mass unemployment etc. so that desperate measures like reducing the AE pension probably along with the basic pension would not be a complete shock. After all, in the last financial crisis, the government putting the boot into public servants is a totally unprecedented way.

 

[WhiteCoat]

Interesting comments Duke of Marmalade. It was remiss of me not to acknowledge your posts in helping me get my head around earnings per share, etc.

This question shows that you have acumen beyond the medical sphere.

I don't know if I'd go that far! But it is true that I have a certain level of interest in finance. The day job necessitates that keen attention is paid to the risks. Have you looked at, for example, the information leaflets accompanying prescribed medications? X% deals with efficacy, etc., multiples of X deal with risks, side effects, contraindicators, etc.

 

[Colm Fagan]

@WhiteCoat @Duke of Marmalade
Thank you both for your contributions and apologies for the delay in replying. I've a few other things on my plate, including preparing for a date with destiny on Monday, at which my Auto-Enrolment proposals will be subjected to careful scrutiny by my peers. I haven't had the time to read recent AAM comments.

On the BadCo question, I don't have much to add to your insightful comments. I particularly like the comment that buying back shares reduces Ryanair's ability to expand its business.

Now onto my auto-enrolment proposals:

how big could the overall fund become when fully mature

I haven't done the sums, but I reckon it could become quite large in an Irish context while still being a minnow in global terms, in comparison to the big sovereign wealth funds, etc. Remember too that the fund will be invested globally, so its size in relation to the Irish economy will be irrelevant.

who underwrites it / what happens if something really, really bad happens in markets when the fund is mature?

No-one will underwrite the fund. As I write in paragraph 16, the smoothed return in any month will be calculated using a mechanical formula. Continuing to quote from that paragraph: "No "expert" judgement will be required - nor will it be allowed. The integrity of the smoothing formula and its independence from outside influence are essential. Maintaining the integrity of the smoothing formula also ensures that auto-enrolment will operate on a mutual basis, with no need for financial underwriting or support from the state or an external financial institution."

That's a bold statement, which is sure to be challenged. It stems from the simple truth (paragraph 11) that "market values are only relevant if assets must be sold". In order to understand the fundamental importance of this simple observation, consider a hypothetical situation of a market collapse when the fund is mature. Let's suppose that, at that time, 80% of the fund's assets are for people who haven't retired and 20% for retired contributors. (I haven't modelled the fund's long-term development, but my gut feeling is that the ratio of funds for retired contributors won't exceed 10% for another 30 years or more, so the 20% estimate errs very much on the cautious side). Assume also that the 20% retired are withdrawing (say) 5% of their fund each year on average. Therefore, the amount being withdrawn in any year is 5% of 20% of the fund, or 1%. Thus, even if active contributors completely stop contributing, only 1% of the fund is being cashed in any year and 99% remains untouched. Of course, the vast majority of active contributors will keep contributing through good times and bad, so the reality is that, even in this Armageddon situation, the fund will still be cash flow positive (and that's before allowing for dividends on existing investments).

The 1% of money exiting the fund in a year will be paid out at smoothed value, which will exceed market value at that time by a considerable margin, but the pain of paying the excess over market value will be shared among the 99% remaining. Market value is irrelevant for that 99%.
I hope that this helps to answer your question.

This question shows that you have acumen beyond the medical sphere.

Hear, hear!

 

[Colm Fagan]

such a scenario would be so dire that much else would be going wrong - food shortages, mass unemployment etc. so that desperate measures like reducing the AE pension probably along with the basic pension would not be a complete shock. After all, in the last financial crisis, the government putting the boot into public servants is a totally unprecedented way.

The governance structures must eliminate (if at all possible) the risk of a government raid on the fund. It should be set up under Trust, with independent trustees who will be accountable to the members. I'm not a lawyer; I leave it to them to set out how that independence should be safeguarded. It's important to recall, though, that, in the last crisis, the government raided private sector pension funds. The existence of independent trustees didn't protect them.

 

[Colm Fagan]

So the investor's share in the non buy back environment includes a percentage of the capital that would otherwise have been used in the buy back together with the additional/marginal directly associated earnings. Is this fair?

I wouldn't dismiss the impact of share buybacks as "marginal". The attached spreadsheet, which I've been updating for my Apple investment for the last few years, shows that earnings per share have grown by an average 16% per annum for the last 5 years, while net income has "only" grown by 10% a year. The difference is due to the share buybacks (net of share awards/ options to employees). Not to be sneezed at.

 

[WhiteCoat]

Hi Colm,

Best wishes in your AE discussions tomorrow. I really hope that it goes well. There are other threads at the moment which illustrate the sub-optimal nature of the existing approach to pensions. This post will be rough and rushed as opposed to than rough and ready.

The reasons I think the fund could become very large are because:

1. It will offer clear blue daylight between existing options so that not alone should it attract the bulk of future pension money but it should equally be attractive to a lot of existing pension money. Existing pension money could come from all over and include, not just private pensions and ARFs, but company DC plans as well as private DB plans (when they wind up given that presumably their days are numbered?) Put another way, who or what could realistically compete with your scheme if it can genuinely deliver what you have set out?

2. I was in Oz in the early 90s. There was a lot of talk about SUPAs. It seemed to be really getting going in earnest around then (sorry I don't have time to check more details of its growth trajectory). What I did check is its current size - something like 2.7 TRILLION! Presumably, these are Oz dollars but even still. I presume that the Oz fund hasn't itself reached maturity? When you adjust this for population size, currency and other factors, you would still end up with a very big number, even if the Irish equivalent became only proportionately as successful.

The reason I think that size matters is because if the fund did become very large, it would have political/structural significance. In the event of a deep and sustained decline in world markets, I could imagine that this would be problematic because a deficit would emerge and this deficit could be very large. For example, would cashflow continue, would there be a run on the fund (with those over the allowable retirement age withdrawing their 25% lump sum), would those under retirement age require guarantees, etc.? Presumably, there would be other factors to address also? If I were the minister in charge, this is the key area in which I would be seeking comfort because a scheme of this nature would invariably be seen as having the state's imprimatur.

If it can be demonstrated that these concerns are not valid or that sufficient safeguards/controls can be introduced to minimise issues associated with really bad stuff happening in the markets, then this really could be a game changer for Ireland.

Please don't feel any obligation to reply before your meeting and best wishes. Thanks also for your post re EPS.....let's leave that one for another day!

 

[Colm Fagan]

@WhiteCoat
I know my first port of call if I ever have a serious medical problem (maybe I should say "another one"). Very insightful indeed.

You'll be relieved to hear that I think I have answers to all your challenges. I don't have time to answer them all now. I hope to give a comprehensive answer after tomorrow (and the answers may depend on feedback tomorrow).

would there be a run on the fund (with those over the allowable retirement age withdrawing their 25% lump sum),

I am proposing that people MUST take their 25% cash at retirement; they won't be able to leave it in the fund and then decide to take it later, precisely for the reason you outline. Neither will they have an option NOT to take the 25% cash on retirement. Also, because the scheme will be restricted (initially at least) to employed workers, with self-employed excluded, there will be limited opportunity for them to time their "retirement" to cause problems for the fund.

I hope to get back to you tomorrow, and thanks again.

 

[Colm Fagan]

First of all, apologies to @WhiteCoat for not coming back to you as promised following Monday's seminar. No, I wasn't silenced by the weight of opinion against me. On the contrary, there was a lot of support for the proposed approach, but also lots of questions, which I hope to set out (and hopefully answer) here and elsewhere. In the meantime, though, my other half thinks that putting up Christmas trees and traipsing round Dundrum Shopping Centre after her are more important than saving the world, so the world will have to wait Of course, if anyone else who was at Monday's meeting would like to add their tuppence worth to the discussion, feel free.
@MikeM My main reading on investments is the online edition of the FT. I don't read much otherwise on investing (but I do read a bit about people and institutions involved in business/ finance) so I'm not in a great position to advise you on reading material. I suggest you open a separate thread, which I'm sure many people will be happy to respond to. For what it's worth, I'm now (while waiting outside shops in Dundrum) reading the book "Bad Blood" about a woman called Elizabeth Holmes and the company she formed, Theranos. One of my favourite reads about the investment world was "Other Peoples Money" by John Kay. I think there's a new version on sale now, with more up-to-date material.

 

[WhiteCoat]

Colm,

Usual caveats about diagnosing remotely aside, it does seem probable that you have pretty advanced HFFWRM syndrome. Regrettably, various clinical studies involving strategies to cope with this condition have not been conclusive and indeed aggressive approaches have led to severe side effects!! Bringing a book, I'm afraid, just provides short-term alleviation of the symptoms but frankly, does not address the underlying issue . It's a tricky one. (Hubby forlornly following wife round mall!)

Joking aside, very pleased to hear that your meeting went well.

 

[Colm Fagan]

@WhiteCoat @Duke of Marmalade: You've both missed your calling as stand-up comics!

Anyway, in more serious mode, I've posted an initial update on Monday's seminar (specifically, what I took from it) under the "Proposed New Approach to DC Drawdown" thread, which seems a more logical home for this discussion.